How are stock market indices calculated?

 The first trading indices were calculated as simple averages. The share prices of all the constituents were totaled and divided by the number of companies. However, today some major indices such as the Nasdaq 100 (US100) and the Hang Seng are weighted averages.

Stock indices are calculated in different ways based on the types of companies they track and the goals of the index. Some index calculations give more weight to stocks with higher prices, while others base the weighting on market capitalization, and others weigh all constituent stocks equally. The two major formulas used to calculate the value of a weighted index are price weighted and market cap weighted.

Price weighted: In price-weighted indices, the stocks are weighted in proportion to their share price rather than the size of the company. This means that companies with the highest share prices have a stronger impact on the value of the index.  Price-weighted indices are less common than those based on market cap. 

Market capitalization-weighted: A market capitalization weighted index uses the value of its constituent companies to rank them. Market cap is calculated by multiplying a company’s stock price by the number of outstanding shares. Companies with the largest market capitalization will have the highest influence over the index’s value.

The market cap of each company is calculated based on free float shares publicly available for trading. A company’s free float market cap is lower than its total market cap, as it excludes shares held by company insiders. The FTSE 100 and DAX 40 are examples of market-value-weighted indices.

Unweight: An unweight, or equal weight index gives the same weight to each of its constituent companies. This limits the influence that one stock can have on the overall performance of the index, reducing volatility while also dampening the effect of a sharp rally in a particular stock.  The S&P 500 Equal Weight Index (EWI) is an equal-weight version of the S&P 500 that offers an alternative for traders looking into trading indices with more price stability.


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